AS FEE-SLASHING RIVAL GEARS UP, OPTIONS BOARD CHIEF SEEKS HEDGE

William J. Brodsky, chairman of the Chicago Board Options Exchange, likes to say he’s in the insurance business — an odd comment for an industry often associated with rapacious speculators. Exchange volume, in reality, is driven by risk-averse customers hedging their stock portfolios.

These days, Mr. Brodsky is busy devising an insurance policy for the exchange, trying to figure out how to protect the franchise from upstart competitors.

Last month, for the first time ever, volume at the exchange — a record 21.5 million contracts — was tops among Chicago’s futures exchanges, and a rebound in seat prices has pushed market capitalization past $1 billion.

But the exchange’s market share of all options volume now hovers around 50%, compared with 62% at the start of the decade. And to say that still another threat looms — an all-electronic, New York-based exchange — is by now a familiar tale for Chicago’s futures industry.

For the options exchange, in particular, the anticipated debut early next year of the International Securities Exchange, bankrolled by E*Trade Group Inc. founder Bill Porter, is both a threat and an opportunity.

The startup’s promise to cut customer fees by 30% already has forced the options exchanges to react, further squeezing profitability and ensuring that worried members will have to bear more exchange-related expenses.

But if new industry entrants, by improving efficiency and market transparency, can lure new business to an opaque field, the CBOE could thrive — provided it adapts.

“Make no mistake: Succeed or fail, non-traditional exchanges will change the dynamics of this industry,” Mr. Brodsky warned this month at the Options Industry Conference in San Diego.

The new exchange plans to trade 600 listed options, fewer than half of the CBOE’s 1,352. The problem for the options exchange is that 392 of them make up 92% of its volume. For all intents and purposes then, everything it has for sale would be listed on another exchange (up from 45%), pressuring margins even more.

Says Mr. Brodsky in an interview: “If people need a wake-up call, that’s a wake-up call.”

Under Securities and Exchange Commission prodding to recruit more industry outsiders, the 21-member CBOE board this month voted to double its number of public directors, to eight, and to shift nominating authority from Mr. Brodsky to a board committee.

The 55-year-old industry veteran, who joined the CBOE two years ago from the Chicago Mercantile Exchange, nevertheless wields more power as both chairman and CEO than his counterparts at other Chicago exchanges, where the titles are split between an elected member and a hired executive.

spending readily

To further reposition itself, the CBOE has been pouring money into new technology, consultants and marketing ventures. Total expenses increased 25% to $126.2 million in the 12 months ended last June, while revenues were growing by less than 10% to $126.5 million.

That left net income a paper-thin $398,700, down drastically from $9.9 million the previous year and off from fiscal 1995’s peak of $13.6 million.

Though revenues are expected to spurt another 10%-plus for the 12 months ending June 30, net income is expected to be pressured for years to come.

Says Victor Meskin, a member since the exchange’s founding in 1973: “Of course it bothers me.” But, like other veterans, he says the exchange is in better shape, mainly on the cost-cutting front, than its futures industry brethren here.

A CBOE seat, in fact, is worth about $90,000 more than a Chicago Board of Trade seat, even though members of the board are automatically granted options exchange trading rights.

Another positive for the options exchange are industry entry barriers related to exponentially greater technical requirements associated with options trading and market making: In the last year alone, as volume has exploded, the number of CBOE “messages” — primarily quotes — has nearly tripled to almost 450 million a month.

The international exchange’s technical guru is a former Australian Stock Exchange official who shepherded that country’s switch to all-electronic options. No such nightmare is in store for the options exchange, predicts Paul J. Bennett, most recently a managing partner of a Chicago options firm.

“There’s a much more competitive environment in the U.S. … and the economies of scale are much greater,” he says. “I think there will be a parallel operation of floors and (computer) screens for some years to come.”

That’s Mr. Brodsky’s hope, though he can’t yet answer his own question, as the new competitor prepares to spend $80 million to ramp up: “If you arm (traders) with the proper technology, will people sitting at screens be better than us?”

employees rattled

He’s sure of one thing: “Look, what we’re saying — the world’s changed. People have alternatives.”

With about 950 staffers, compared with the 70 to 80 envisioned by the start-up, the option exchange’s cost-structure challenges are obvious. Talk last fall of “offloading” marketing and other expenses to the Options Industry Council rattled CBOE employees.

For the industry and its well-managed survivors, however, the pie will get bigger, notes Bernie Schaeffer, publisher of Cincinnati-based newsletter Option Advisor. (Industry volume was up 21% last year and another 28% through last month.) New electronic exchanges are “an unambiguous win for the investing public,” he argues.

As for the options exchange, suggests Gary Katz, the International Securities Exchange’s senior vice-president for marketing and business development: “They’re just not going to stick where they are and watch the revolution roll over them.”

Crain News Service